Why do foreign countries compete in currency devaluation?

Slowing economic activity and dim export prospects have a negative influence on the international market economy. As a result, the first months of 2009 showed that more and more countries have started to pursue “competitive devaluation” strategy to support their export, attract foreign investment and buffer the impact of a deepening global recession. However, some experts believe that devaluation is “beggar-thy-neighbour” policy that can aggregate uncertainties in global financial markets.

The currency devaluation statistics is alarming. There are dozens of resource-rich countries that have seen their currencies fall against the dollar over the last several months. These countries include Brazil, South Africa, Mexico, Russia and Belarus. 

Armenia weakened its currency by 22% against the dollar. The bank of Kazakhstan devalued the tenge by 18%. India, Malaysia and Taiwan have let their currencies fall after South Korea weakened it currency by 19% against the dollar. 

The U.K. pound dropped 23% against the euro last year. Currencies from Hungary, Czech Republic, Ukraine, Colombia, Poland, Chile, and Turkey have depreciated more than 30%. The worst performer is Iceland. Its currency fell by 51% since July 2008.

If this dramatic trend continues, we are likely to see many more new countries weakening their currencies. The level of devaluation can reach the figures similar to those observed during the Asian crisis in 1997-1999. Why doest it happen? 

Why do countries devalue their currencies?

Devaluation, in its common modern usage, means an official lowering of the value of a country's currency. For most countries, devaluation is an inevitable option in today’s uncertain economic climate.

The main argument is that devaluation helps export become more competitive. The domestic currency will be cheaper relative to other currencies, so a country's export will be less expensive for foreign customers. 

The next important effect of devaluation is that it makes foreign goods more expensive for domestic consumers. Thus people will prefer buying local products rather than foreign ones. This may help decrease import and reverse the balance of payments deficit. Thereby depreciation works similar to an export subsidy and import taxes.

Let’s illustrate the advantages of devaluation. Although nowadays this process occurs in terms of all currencies, we will take just one currency to simplify the example. For example, if Russia is losing money trading with France, it can devalue the Russian ruble by 20%. Let’s assume that one euro was worth about 28 rubles several months ago. The 20% devaluation will make it cost about 34 rubles. 

The ruble devaluation will make French goods more expensive for Russian consumers. For example, a bottle of French wine previously cost on average 20 euros in France and 560 rubles in Russia. Now it still costs 20 euros in France, but 680 rubles in Russia. Many customers will refuse to buy this wine. Instead, they will pay more attention to Russian production. 

Plus, Russian products will become cheaper for Frenchmen. It means that people will tend to buy goods from Russia instead of goods from Germany or Italy. So the result of such devaluation is that Russian export will likely to increase and import will likely to decrease. This strategy will help the government reduce the current account deficit. 

There are some more arguments that can make a country decide to weaken its currency. For example, a government might try to use devaluation to raise aggregate demand in the economy in order to reduce the level of unemployment. The logic is simple: people start to buy more local goods, so the companies need more people to produce, sell, ship, etc. these goods. 

Devaluation effects

On the one hand, most of the currency declines are understandable. They are necessary to help countries increase export and stimulate the consumption of domestic goods. This helps to support local markets when consumer demand is weak or declining.

On the other hand, this strategy has been heavily criticized by the financial press and the banking community. They think that depreciation can be destabilizing and even cause social and economic disruption. Why?

The main concern is that by making import more expensive and increasing demand for domestic goods, devaluation can also lead to inflation and higher interest rates. It will slow the economic growth.

Then, devaluation can start a snowball effect of repeated devaluations. For example, if countries A and B are trading with each other and country A weakens its currency, then country B may decide that this move has a negative affect on its export industries. In turn, it can devalue its own currency to offset the effects of the trading partner's devaluation.

We can see this situation right now. Trying to support their export and reduce import penetration, numerous countries have been forced to weaken their currencies to keep up with the competitive devaluation (when a lot of economies weaken their currencies against each other). Many other countries face similar choices to buffer the impact of this strategy.

Such “beggar-thy-neighbour” policy can exacerbate economic difficulties by creating instability in global financial markets. If a lot of currencies devalue at the same time, it puts downward pressure on the prices of import and leads to deflation in foreign markets. 

Sudden and large declines in commodity prices have made the terms of resource trading worse. At the same time, western countries don’t have enough funds for purchases due to the deepening recession and financial crisis. So if large manufacturing countries will pursue this competitive devaluation strategy, then we can face more serious difficulties.

Charles P. Kindleberger, a historical economist and author of over 30 books, told that competitive devaluation was one of the reasons of the Great Depression. This time it might lead to Global Depression.

Since the 1930s, there were established numerous international organizations such as the International Monetary Fund (IMF) to help countries coordinate their trade and foreign exchange policies in order to prevent repeated devaluations. The 1976 revision of Article IV of the IMF charter was written to avoid "manipulating exchange rates...to gain an unfair competitive advantage over other members." 

Maintaining a currency’s value under the pressure of competitive devaluation can be rather costly. For example, Russia has spent around $8 billion trying to defend the already weakened ruble. Kazakhstan spent $3.5 billion, or 16% of its foreign-exchange reserves to support the tenge. And the longer this process lasts, the more money it requires. 

Depreciations also raise a foreign currency debt. For example, for countries such as Bulgaria where banks have borrowed funds in dollars or euros and have given loans in lev, depreciation would mean great losses. 
In addition, don’t forget about the psychological risk of devaluation. It can be considered as a sign of economic weakness of a country. The creditworthiness of the nation may be jeopardized. It means that devaluation can significantly lower investor confidence in the country's economy and hurt the ability to attract foreign investment. 

As a conclusion, let’s analyze the today’s results of devaluation. As we have already mentioned, there are many countries that have weakened their currencies by 10-30%. However, it has not helped to increase their export a lot. The December statistics indicates a universal decline of 25-30%. The drop in consumer demand in many sectors is so great that depreciations are not able to boost it.